Sunday, October 9, 2016

When Genius Failed (Chapter 4)

In 1994, LTCM earned 28 percent
which is a lot due to the fact that the average bond investor had lost
money.J.M. would write a letter to his
investors on the possibility and odds of losses in the future and for investors
to not expect a repeat.Merton and
Scholes used their advanced math knowledge to devise precise mathematical odds
of when and how much they could possibly lose.

LTCM tried to quantify every aspect
of trading, associating past volatility with their assessment of future
risks.They were basically conducting an
experiment in managing risk by numbers.LTCM trades were an attempt at exploiting spreads that reflected what
they seemed to be inaccurate future volatility risk.Black-Scholes made an assumption that the
volatility of a security is constant.Merton took that assumption a step further and assume that prices would
trade without any jumps.Merton found
that a trader who owned both the price of an option and the price of the stock
could operate in a perfect, risk-free arbitrage.This would become an essential building block
in LT’s hedging strategies.

There were multiple people who
either studied under or with Black, Scholes, and Merton that found inaccuracies
in their assumptions, such as Eugene Fama.He discovered that there were many more days of extreme price movements
than would occur in a normal distribution.The tail ends of the distribution differed from that of Merton’s because
due to the fact he thought of them to be swollen.Such an example was Black Monday.

Over the first two years, LTCM had
only one month which they lost more than 1 percent.Their equity capital had almost tripled to a
total of $3.6 billion in that time.

Question:

Why do financial markets run to extremes more
often than say, a coin flip?How would
this impact the market and investors?

7 comments:

I think that financial markets tend to have more extreme points than fifty-fifty type spreads like a coin toss because of who controls these two actions. A coin toss is controlled by a coin and there little to no power a human can put on the outcome of a coin toss after they release the coin from their hand. Financial markets on the other hand, are run by humans and are managed by them. Human investors see the same opportunities and it leads to everybody moving in that direction. If you see your friend is returning over 10% in one area of the market while you are returning a measly 2% isn't it likely you will choose to enter his section of the market? This sort of human desire to make money and do better for themselves leads to the tunnel vision that causes recessions sometimes. The housing market of 2007-2009 is a great example in that everybody was buying and selling the subprime mortgages because they saw it as an investment with great returns but did not actually pay attention to what they were buying and the repercussions it might have in the future. This human factor in financial markets is what causes it to have extreme effects and periods of great economic growing and a booming economy, as well as economic slowdowns and periods with little to no growth in the economy.

I agree with Jacob. A coin toss has the same probability every time of success or failure. The financial markets take into account previous trends as well as current trends to understand and predict what the market might be doing, declining or growing.

Going off of the previous two comments, I think this ties into Lowenstein's comments on risk and uncertainty. With something like rolling dice, or flipping a coin there is always risk, but there is no uncertainty "because you know for certain the chances of getting a 7 and every other result" (63). Lowenstein goes on to comment that through the revolutionary way Long-Term was presenting and calculating it's risk it was in a way taking away the uncertainty part and making it like a coin flip. When Lowenstein discusses the "Normal Bell Curve" he again points out how Black, Scholes, and Merton took on this idea, that while price changes are random, they will eventually create a bell curve just like a dice roll would. However, this is ignoring the human factor mentioned in earlier posts. When it comes to investment, while some may be willing to trust the numbers and the bell curve, when others see money being lost at the extremes, or even at a more normal amount, other investors will react and push the results even more to one extreme or the other.

The problem with financial markets is that they do not have a normal bell curve, instead they have "fat tails" (72). This due to the fact that markets do not operate independently, like a roll of the dice, but have expectations that an event will happen after it has occurred x times previously.

Financial markets tend to run towards extremes more than an even distribution over the long term like a coin toss would due to the power of human thought and opinion. The possibilities are different in the two scenarios: coin tosses can go one of two ways, whereas a financial market can be all different areas in between. Maybe its not the best analogy, but I think coin tosses are discrete, as in they have defined values of heads/tails, whereas financial markets, opportunities and numbers can be continuous and constantly changing. As Jacob said, the fact that humans are running the markets is incredibly important in affecting how they run. A lot of group think can happen and market perception and the opinions of trusted sources can be another factor in why it seems individuals run towards one action, then all turn and run towards another (to be honest, I think of Sheep). Essentially these are trends. Movement is dictated by how valuable an action is seen as, not necessarily by the true meaning or consequences that it may cause. Humans are motivated to fulfill needs and then unlimited wants and how we perceive this phenomenon definitely depends on if we believe humans are truly rational. Lowenstein speaks to the Black-Scholes formula, which uses a partial differential equation, states, that it assumes that "ideal conditions...the stock price follows a random walk in continuous time" (p. 66). Price changes are essentially assumed to be random and the distribution over the longer term period would resemble the pattern of a bell curve. However, this may not be accurate since each event does not happen independent of the others, and is rather dependent on the past and future expectations. This causes a run to extremes, which is why there are "fat tails" (p. 72). Merton's model is written in an ideal state and missing out on what is referred to as the "human spirit" (p. 74), which I would simply just call the fact that humans not unbiased, uninfluenced, logical robots or simplistic coins, are involved in the system.

In financial markets may lean to one side or the other depending on the current state of the market. Flipping a coin gives them a 50/50 chance for one side or the other without taking into account the state of the actual market. With the coin flip the human element is taken out, the fate of the decision is based on a 50/50 probability.

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